Yesterday hedge fund manager David Einhorn made public an open letter to AAPL shareholders, publicizing his suggestion that the company issue perpetual preferred stock to shareholders.
mechanics of the issue
AAPL has no debt and $137 billion of cash on its balance sheet. It is generating cash flow at the rate of about $40 billion a year.
Einhorn proposes that AAPL issue a new security for free to shareholders that would pay a total yearly dividend of $2 billion.
The new security would:
–be perpetual, meaning it would go on forever (or until AAPL goes out of business). This also means the preferred would have no redemption value, that is, it could/would never be returned to AAPL in exchange for a cash payment
–be cumulative, meaning any unpaid dividends would continue to be obligations of AAPL, rather than simply lost, as is the case with dividends on common stock
–have a dividend preference over the common, meaning the preferred dividend–and any accumulated unpaid ones–would have to be paid before a common could be.
valuation
In round numbers, AAPL has a billion shares outstanding. One way of implementing the Einhorn proposal would be to distribute one share of preferred for each common share held. If so, the preferred would pay an annual dividend of $2.
How much would you pay for a potentially infinite stream of $2 annual payments? Einhorn tried to frame the issue psychologically by saying this is “$50 billion” worth of stock, or $50 a share if the issue were constructed as I describe. This would also be a 4% yield.
Especially for the first issue of this type, $50 could be low. Yes, it represents 25 years of undiscounted dividend payments. But AAPL is a pristine credit. The yield is a huge premium to the 30-year Treasury. There are tons of AAPL fans who might like a “cheap” way of owning an AAPL security–AAPL has (foolishly, in my view) chosen so far not to tap this base of support by splitting its common. And the preferred issue would have novelty value.
an investor’s view
–The proposed preferred has no claim on AAPL’s assets and represents only a tiny fraction of the company’s cash flow. It wouldn’t have voting rights under normal circumstances. So it isn’t equity in any practical sense. Arguably, therefore, its issuance might have no effect on the price of AAPL common. In all likelihood, any negative effect would be tiny. There’s even a (lottery ticketholder’s) chance that the effect would be positive.
So the Einhorn proposal is like creating free money, as I wrote yesterday.
–Einhorn’s hedge fund clients hold about $500 million worth of AAPL. Einhorn himself gets some percentage, say, 20%, of the profits they make on his investment choices. An AAPL preferred issuance could represent a $10 million payday for him.
–-The preferred is not a one-and-done story. There’s no reason why this magic trick can’t be repeated at least several more times, each one giving a $50 billion boost to aggregate shareholder wealth.
–What’s not being said is that the pledge of future cash flows puts handcuffs on management, for good or for ill. Each $2 billion in cash flow dedicated to preferred dividends means less that management is free to use for capital expenditure, acquisitions or other uses. The preferred can be regarded as a prudent safety measure. Look at Hewlett-Packard–a once-great company that has squandered an enormous amount of its shareholders’ money through a decade of lunatic, management- and board-approved acquisitions.
AAPL’s
–Q: Who are these guys to tell us what to do? They don’t work here.
A: They’re the owners. You work for them.
Reply: That can’t be right.
–About 3/4 of AAPL’s cash is held outside the US, so it’s only available to pay preferred dividends if it’s repatriated. That would mean paying income tax at 35% on anything that’s brought back.
–If we assume AAPL generates its global cash flow in the same proportions as its cash holdings, then only $40 billion annually is available to pay dividends of any type. $10 billion+ already goes to pay the common dividend.
If shareholders say they think Einhorn has a good idea (which he does), then management has potentially got to focus a lot more on earning money in the US.
my 2¢
There’s a tipping point out there somewhere, after which the Einhorn trick will no longer work. Not a current worry, though.
There’s also a legitimate concern that at some point the diversion of cash flow away from reinvestment in the firm will hamstring management and hamper growth. With $137 billion in the bank, not a concern, either.
weird stuff from the AAPL high command
In the old days, Steve Jobs would have thrown Einhorn out of his office and that would have been case closed.
IN contrast, current management is seeking to change the company’s charter to outlaw preferreds like Einhorn’s. Not only that, it’s taking a page from Congress’s book, wrapping the change inside a bunch of others that are supposed to be voted on as a group. So the owners don’t get a say so on the Einhorn idea alone.
These action has, predictably, had the opposite of the intended effect. It’s publicized the Einhorn proposal like nothing else ever has. It makes management look weak. And it makes AAPL look like it has something to hide. (My candidates: the small amount of cash flow generated in the US; the dilutive effect of management stock options, which are obscured by stock buybacks out of US-held cash.)
what would I do?
I’m not a current holder–to my regret, although I did buy AAPL for my clients (including me) in 2004. But if I were, I’d back Einhorn.